Showcase of Australia and Korea
Many people have the impression that equities and currencies are independent classes of assets. While that may be true in principle, it’s hardly the case in practice.
For this reason, the global investor has to consider the linkages amongst different types of assets. The forces at work are examined in connection with a couple of stark examples involving Australia and Korea. The case studies happen to involve divergent cultures and distinct time scales, but the crucial patterns crop up regardless.
Bogey of Foreign Exchange
In a global economy, the payoff from an exchange traded fund depends in part on the action in the currency market. The outturn of foreign exchange plays a vital role in boosting or slashing the return on investment. Vivid examples of this sort are found in the markets of Australia and Korea.
At times, the behavior of the currency can outshine or reverse the action in the target market. It makes little difference whether the investment involves a financial instrument like a stock or bond, or a tangible object such as real estate.
The exchange rate adds an additional layer of risk to an international investment. The fortunes of the currencies in the respective countries could uplift the gain or pummel the payoff in a big way.
Linkage of the Currency and Stock Markets
By and large, the local currency moves in tune with the stock market. When the bourse rises, so does the currency; and vice versa.
The linkup between the two markets is spotlighted by the experience of Korea. The chart below, adapted from Bloomberg (bloomberg.com), covers a period of 5 years ending in February 2011.
The orange line shows the relative performance of the Korea Composite Stock Price Index (KOSPI) throughout the stretch. Meanwhile, the value of the currency with respect to the U.S. dollar is depicted by the green curve.
An obvious feature of the chart is the tie-up between the currency and equity markets. Although the behavior varies in detail, both types of assets tend to swell and swoon in unison.
Another blatant trait involves the difference in the size of the swings. In particular, the bourse is seen to be a lot more volatile than the currency.
Both of the foregoing traits are in fact hallmarks of the financial forum. In other words, the tie-up as well as the divergence of the markets are prone to show up in connection with other countries dotted round the world.
Impact of Forex on an ETF
Another showcase lies in Australia. Here, too, the currency tends to move in tune with the bourse.
The chart below, adapted from the Wall Street Journal (wsj.com), spans a period of 2 years ending in February 2011.
The purple line shows the relative performance of the All Ordinary Shares on the Australian Securities Exchange (XAO). As the chart shows, the benchmark rose by nearly 50% over the entire span.
Meanwhile, the pear color portrays the path of the CurrencyShares Australian Dollar Trust, an index fund whose goal is to track its namesake. The vehicle trades in the U.S. under the ticker symbol of FXA.
Lastly, the green arc depicts the tracking fund in the U.S. called the iShares MSCI Australia Index (EWA). In keeping with its name, the underlying goal of the vehicle is to mirror the action of the XAO.
By contrast to popular perception, the performance of EWA differs greatly from the turnout of the Australian exchange. The reason, of course, is that the index fund is priced in terms of the U.S. dollar. For this reason, the value of EWA depends not only on the fortunes of the stock market down under, but the movements of the southern currency as well.
During the period covered by the chart, the stock market as well as the currency in Australia each rose by roughly 50%. On the other hand, the ETF based in the U.S. surged in excess of 100%.
Naturally, an ETF does not track its target market with perfect accuracy. Even so, the difference in performance is apt to be nominal for an index fund which is constructed and managed in a sensible way.
Given this backdrop, an ETF whose goal is to track a foreign market will in general embody the performance of the target asset as well as the exchange rate. The entanglement can work to the benefit as well as the detriment of the international investor.
Wrap-up of a Double-Edged Sword in Global Investment
The foregoing charts include the stretch in which the global economy was slowly recovering from the financial crisis of 2008. For this reason, the bourse as well as the currency were prone to trudge upward in many countries round the world.
As noted earlier, though, the linkage between equities and currencies can crop up in the downward direction as well. For instance, a cutdown of the stock market in Australia is likely to drag down the local currency in tandem.
Many folks have the impression that stocks and currencies are independent classes of assets. The misconception is spotlighted by the argument that an investor can diversity their portfolios by investing in foreign currencies as well as equity assets. While the argument might be plausible from a conceptual stance, it’s largely flawed from a pragmatic standpoint.
The foregoing examples underscored the fact that distinct classes of assets are intertwined rather than independent. In fact, the action in any market may have a huge impact on the behavior of the others.
An exemplar lies in the role of the exchange rate in fixing the payoff from a stock market located abroad. Due to the forces at work, along with the interactions involved, a lucid program of global investment has to take into account the hefty impact of the forex market on stocks as well as other types of assets.
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